Fleming Cardiovascular, P.A. v. Commissioner
Qualified Business Appraiser and Appraisal Needed
A November 2015 memorandum by the U.S. Tax Court in Fleming Cardiovascular, P.A. v. Commissioner found that the Internal Revenue Services (“IRS”) did not abuse its discretion in revoking the Fleming Cardiovascular, P.A. Employee Stock Ownership Plan’s (“ESOP”) qualified and tax exempt status for failure to operate in accordance with plan documents. Of note, the ESOP failed to obtain an independent annual valuation of the stock by a qualified appraiser in five out of seven plan years.
A November 2015 memorandum by the U.S. Tax Court in Fleming Cardiovascular, P.A. v. Commissioner found that the Internal Revenue Services (“IRS”) did not abuse its discretion in revoking the Fleming Cardiovascular, P.A. Employee Stock Ownership Plan’s (“ESOP”) qualified and tax exempt status for failure to operate in accordance with plan documents.¬† Of note, the ESOP failed to obtain an independent annual valuation of the stock by a qualified appraiser in five out of seven plan years.
In a declaratory judgment proceeding, the Tax Court was tasked with determining whether the IRS abused its discretion when it: (1) issued a final revocation letter to Fleming Cardiovascular, P.A. (“Company”) concluding that its ESOP was not qualified under Internal Revenue Code (“IRC”) section 401(a) and that the related trust was not exempt under IRC section 501(a) for the plan year ending on December 31, 2004, and all subsequent plan years; and (2) revoked the favorable determination letter issued to the plan dated June 1, 2005.
Dr. Robert Fleming formed Fleming Cardiovascular, P.A. on May 14, 2004; on May 28, 2004, the Company adopted the Fleming Cardiovascular, P.A. ESOP.¬† On June 1, 2005, the IRS issued a favorable determination letter stating that the ESOP was qualified pursuant to section 401(a) and the related trust was exempt from income tax pursuant to section 501(a).
According to the plan document, Company employees could participate in the ESOP if they were at least 21 years old and had achieved one year of service.¬† The Form 5300 (Application for Determination for Employee Benefit Plan) represented that Fleming Cardiovascular had two qualified employees at the time the ESOP was adopted.¬† Dr. Fleming allegedly began participating in 2004.
In a letter mailed to the Company on August 29, 2012, the IRS proposed to disqualify the ESOP.¬† In its letter response, the Company explained that the reason there were no employees from 2004 through 2009 was because there was a court-ordered injunction against the practice in those years as a result of Dr. Fleming’s violation of a five-year covenant not to compete restricting his ability to practice medicine in the Wichita area.¬† The Company claimed, “Dr. Robert Fleming was employed starting July 2010 and was over 21 years of age as of May 13, 2004.”
The Company issued five shares of its Class B common stock to the ESOP trust on December 30, 2004, and 48.06 shares on December 15, 2005, with the ESOP trust allegedly paying $50 and $409,253 for the shares, respectively.¬† All of the shares were allocated to the rollover portion of Dr. Fleming’s account.¬† In 2004, Dr. Fleming had received a $408,543 distribution from his individual retirement account.¬† The ESOP trust did not have a bank or brokerage account.
The plan documents also required an annual valuation of the stock by an independent appraiser.¬† An accounting firm prepared a valuation for the 2006 plan year, but neglected to include the certifications demonstrating the appraiser’s independence.¬† The same firm allegedly prepared a valuation for the 2005 plan year, although none was included in the administrative record.¬† For the 2007 plan year, a valuation report that met the independent appraiser requirements was prepared.¬† Valuation reports were not prepared for 2004, 2008, 2009, or 2010.
On February 12, 2013, the IRS issued a final revocation letter, stating that the ESOP and the trust failed to qualify under sections 401(a) and 501(a) for plan years 2004 through 2010 because:
- the ESOP was not operated in accordance with the original plan document (including not receiving the required independent valuations in most plan years);
- the Company did not make recurring and substantial employer contributions; and
- a participant’s (Dr. Fleming’s) annual additions exceeded the limitations prescribed by section 415.
The Company filed a petition with the Tax Court seeking a declaratory judgment sustaining the continuing qualification of the ESOP and tax exempt status of the trust.
The Tax Court reviewed whether the IRS abused its discretion, noting that the determination of disqualification would hold unless it was “unreasonable, arbitrary, or capricious.” ¬†The Tax Court stated that any one of the reasons cited by the IRS in its final revocation letter would be enough to disqualify the ESOP and the trust, and that failure to meet section 401(a) is considered a continuing failure that disqualifies the plan for subsequent years.
An employee benefit plan is qualified, and the associated trust is a qualified trust, when the terms of the plan’s document, and its actual operations, meet the requirements of section 401(a).¬† A qualification failure, also called an “operational failure,” occurs when a plan is not operated in accordance with its terms.
In the case of Fleming Cardiovascular, the Tax Court found that Dr. Fleming was allowed to participate in the ESOP despite not having received compensation from the Company in 2004, and not having achieved the “year of service” requirement.¬† Since failure to follow the terms of the plan document is a continuing failure, the ESOP was not qualified, and the trust was not exempt, for 2004 or any subsequent plan year.
With respect to the valuation of the stock, the plan document required a determination of value by an “independent appraiser,” which the Tax Court equated to a “qualified appraiser” as defined in the IRC and the Income Tax Regulations.¬† No appraisals were provided for the Fleming ESOP for the 2004, 2005, 2008, 2009, and 2010 plan years.¬† For 2006, an appraisal was prepared by an accounting firm, but necessary information identifying the appraiser as qualified was excluded.¬† The Tax Court found failure to follow the plan document with respect to annual valuations to be an operational failure.
With respect to annual additions in excess of section 415 limits, the Tax Court found that the allocation of 53.06 shares of stock to Dr. Fleming’s account for 2004 and 2005 exceeded the limitation because he did not receive compensation from the Company in those years.¬† Further, the argument that the amounts were rollover contributions from Dr. Fleming’s individual retirement account and should not be considered for purposes of section 415(c) was not accepted because there was no evidence of a valid rollover, and because the ESOP trust did not have a bank or brokerage account, making such distributions impossible.¬† The Tax Court found this to be a continuing failure that disqualified the plan for all subsequent years.
In conclusion, the Tax Court found that the IRS did not abuse its discretion when it determined that the ESOP was not qualified under section 401(a), and the trust was not exempt under section 501(a), for the plan year 2004 and all subsequent plan years.¬† Further, it was not an abuse of discretion to revoke the favorable determination letter issued to the ESOP on June 1, 2005.
This case highlights the importance of engaging qualified advisors to develop plan documents that are consistent with current tax laws, and then following those plan documents in the actual operation of the qualified plan.¬† In Fleming Cardiovascular, P.A. v. Commissioner, this was particularly true with respect to obtaining annual independent valuations of the stock owned by the ESOP. ¬†View case here.
 Section 415(c) limited annual additions to a participant’s account to the lesser of $41,000 or 100% of the participant’s compensation in 2004 and to the lesser of $42,000 or 100% of the participant’s compensation in 2005. Annual additions exclude rollover contributions.
Heidi P. Walker, CPA, ABV, ASA is a Managing Director in the Portland, Maine office of Meyers, Harrison & Pia Valuation and Litigation Support, LLC. She specializes in the valuation of transactions involving employee stock ownership plans. She has also performed numerous valuations of business interests for both litigation and non-litigation purposes, including matrimonial dissolutions, shareholder disputes, estate and gift tax planning and filing, business damages, buy-sell agreements, mergers and acquisitions, and breach of contract. She has significant experience as a jointly-retained financial expert in litigation.
Ms. Walker can be reached at (207) 775-5111 or e-mail to firstname.lastname@example.org.